Question

The team management of a jewlery store plans to buy gold in the future and seeks protection against an increase in the price of gold. The current price of gold is $352.40 per ounce. The futures price of gold is $397.80 per ounce. The number of ounces to be hedged is 1,000, and the number of ounces per futures contract is 100. Therefore, 10 contracts will be hedged.

1) Describe in detail the hedge created by the jewelry store. That is what actions would be taken and why?

2) Based on the information given in the question, describe the outcome in detail of this hedge if the price of gold is $304.20 per ounce and the price of the futures contract is $349.60 per ounce when the hedge is lifted.

3) Based on the information given in the question (not your answer above, but the original information), describe the outcome in detail of this hedge if the price of gold is $392.50 per ounce and the price of the futures contract is $437.90 per ounce when the hedge is lifted.

Any information as to how you came to the answer will be helpful as i am trying to understand the information. Thank you!

Answer 1

Hi,

Ill help you with all the detailed explanation.

1) Describe in detail the hedge created by the jewelry store. That is what actions would be taken and why?

Inorder to Hedge the jewelry store needs to be eliminate the price risk by locking in todays price, below is the hedge details to lock the prices.

• Buy Futures (Price rise will be eliminated by this)
• Buy Gold after hedge is lifted

2) Based on the information given in the question, describe the outcome in detail of this hedge if the price of gold is $304.20 per ounce and the price of the futures contract is $349.60 per ounce when the hedge is lifted.

Information at time of hedge (t = 0)

• Cash price = $352.4
• Futures price = $397.8

Information at end of hedge (t = When he wants to buy the gold in future)

• Cash price = $304.2
• Futures price = $349.6

Hedge details of the jewelery store:

Cash market:

• At the time hedge is lifted value of 1,000 oz = 1000 * $ 304.2 = $ 304,200
• At the time hedge is placed value of 1,000 oz = 1000 * $352.4 = $ 352,400
• Summary (cash market) = 352,400 - 304,200 = 48,200 (Gain)
• Instead of buying at 352.4 he bought it @ 304.2

Futures market:

• Buy 10 futures, 10 * 100 * $ 349.60 = $ 349,600
• Sell those 10 futures, 10 * 100 * $ 397.8 = $ 397,800
• Summary (Futures market) = 349,600 - 397,800 = - $ 48,200 (Loss)

Therefore net position = $ 0, a perfect hedge.

3) Based on the information given in the question (not your answer above, but the original information), describe the outcome in detail of this hedge if the price of gold is $392.50 per ounce and the price of the futures contract is $437.90 per ounce when the hedge is lifted.

Information at time of hedge (t = 0)

• Cash price = $352.4
• Futures price = $397.8

Information at end of hedge (t = When he wants to buy the gold in future)

• Cash price = $392.5
• Futures price = $437.9

Hedge outcome details:

Cash Market:

• At the time hedge is placed value of 1,000 oz = 1000 * $352.4 = $ 352,400
• At the time hedge is lifted value of 1,000 oz = 1000 * $ 392.5 = $ 392,500
• Summary (cash market) = 392,500 - 352,400 = 40,100 (gain)

Futures market:

• Buy 10 futures, 10 * 100 * $ 437.9 = $ 437,900
• Short 10 futures, 10 * 100 * $ 397.8 = $ 397,800
• Summary (Futures market) = 397,800 - 437,900= - $ 40,100 (Loss)

Therefore net position = $ 0, a perfect hedge.

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